Oil Price: WTI – Brent Spread Scaling $9 Again

This is the fourth time in the last six months that the WTI – Brent spread has exceeded $9 per barrel. In the previous three instances, the spread then quickly narrowed to $4, $5.50 and $3. The spread opened up a few years ago with the large increase in oil production in the United States. Because the US does not allow the export of crude oil, a chronic glut in certain grades has resulted in a discount of the US price (WTI) to the global price (Brent).

The instability of Middle Eastern oil supply (notably from Libya and Iraq) and the current spat with Russia over Ukraine have created new pressures on the US to allow oil exports. Until then, the large spread creates a competitive advantage for the US economy, and lower costs for manufacturers, utilities, refiners and transport industries.


European GDP: What Went Wrong

12 August 2014


(also published at Seeking Alpha)

First the two world wars, then a decline in the birth rate.

Newspapers these days are full of stories on World War I which started 100 years ago. They are also full of stories on today’s anemic European economy, as for example with Italy’s negative growth rate in the second quarter and France’s struggle to reach 1% GDP growth this year. At first blush, these two sets of stories are unrelated. But on closer look, it is apparent that the economy today is a distant echo of the war a century ago. And it all comes down to Europe’s demographics.

4 August 1914

4 August 1914 (via Wikipedia)

In my view, there are essentially three main catalysts of economic growth: innovation, demographics, and a favorable institutional framework. To illustrate this, imagine that a firm develops the best smartphone in the world but that there is only a potential market of 1 million buyers. Clearly, the wealth created by this innovation would be far smaller than if the potential market was 100 million buyers. Thus the importance of demographics.

Now imagine that there is a market of 1 billion people but that there is no innovation of any kind. In this case, wealth creation would be greatly stunted and, with few new assets being created, wealth would become essentially a game of trading existing resources. Thus the importance of innovation. Finally, imagine a country where institutions are weak, where contract law is weak, where access to capital is difficult, where the government is corrupt and political risk is high. Here again there would not be much innovation because there would not be much capital or much incentive to innovate. Thus the importance of a favorable institutional framework.

Too many deaths

So going back to Europe, we could say that it has some innovation and that it has a favorable institutional framework, though in both cases to a lesser extent than the United States. What Europe lacks most is a strong demographic driver. It is enlightening in this regard to look at the sizes of European populations in the year 1900 vs. today:

 Population (millions)  1900 2014 Growth CAGR  TFR 
France 38 66 74% 0.5%  1.98
Germany 56 81 45% 0.3%  1.42
Italy 32 61 91% 0.6%  1.48
Russia 85 146 72% 0.5%  1.53
Spain 20.7 46.6 125% 0.7%  1.50
United Kingdom 38 64 68% 0.5%  1.88
Brazil 17 203 1094% 2.2%  1.80
China 415 1370 230% 1.1%  1.66
Egypt 8 87 988% 2.1%  2.79
India* 271 1653 510% 1.6%  2.50
Indonesia 45.5 252 454% 1.5%  2.35
Japan 42 127 202% 1.0%  1.41
Mexico 12 120 900% 2.0%  2.20
Nigeria 16 179 1019% 2.1%  6.00
Philippines 8 100 1150% 2.2%  3.07
United States 76 318 318% 1.3%  1.97

* includes India, Pakistan, Bangladesh and Burma.

Source: Various, United Nations. Data may include errors. Estimates vary due to shifting borders and uneven reporting.

Two important points stand out:

First, in 1900, European countries were not only the world’s economic and military powers. They were also among the most populous countries in the world. By contrast today, Russia is the only country in the top 10 most populous. Then Germany is 16th and France is 20th. More importantly, some of the new demographic powers, India, Nigeria, Egypt, Mexico, the Philippines and Indonesia, are growing at a healthy clip, as can be seen from their Total Fertility Ratios (TFR, see table) whereas European countries are growing very slowly at TFRs that will ensure stagnation or shrinkage in the sizes of their population. A ranking ten or twenty years from now may show no European countries in the top 20 most populous countries.

Second, comparing European population sizes in 2014 vs. 1900 reveals a very slow annual increase in the 114 year period. And this is where the effects of the two World Wars, of the Spanish Influenza and of communism can be seen. Populations have grown with a CAGR of less than 1% per year for the last 114 years.

The United States had fewer casualties in the two World Wars, more immigration and a strong post-war baby boom, resulting in a healthy 1.3% population CAGR and a near quadrupling of the population over the past 114 years. However, as I wrote previously, the US faces slower, sub 1% population growth in the next few decades.

Here is the tally of deaths for some countries in the two World Wars:

 Millions of deaths  WW1 % of pop WW2 % of pop
 France    1.7 4.3%   0.6 1.4%
 Germany    2.8 4.3%   8.0 10.0%
 Italy    1.2 3.3%   0.5 1.0%
 Soviet Union    3.1 1.8% 22.0 14.0%
 UnitedKingdom    1.0 2.0%   0.5 0.9%
 United States    0.1 0.1%   0.4 0.3%

 Source: Various. Estimates vary widely and may include errors.

Estimates of deaths from the Spanish Influenza of 1918-19 vary widely from 20 to 50 million people worldwide. And Stalin’s purges are estimated to have killed over 20 million. Tens of millions of people and a larger number of descendants would have been added to today’s European population had these events not occurred. I made the case last year that Europe’s economies and markets suffer from weak domestic demand and have for a long time been driven by events outside of Europe itself.

Too few births

In general, a large number of countries are facing a more challenging demographic period in the next fifty years compared to the last fifty. Since the 1970s, there had been a steady decline in the dependency ratios (the sum of people under 14 and over 65 divided by the number of people aged 15 to 64) of the US, Western Europe, China and others. This decline is explained by a lower birth rate and was accelerated by large numbers of women joining the work force in several countries. There were fewer dependents and more bread winners than in previous decades.

In future years, dependency ratios are expected to rise due to the aging of the population in most countries and a decline in the number of workers per dependent. In the United States for example, baby boomers are swelling the number of dependents who rely on younger generations to support them in retirement (whether through taxes or through buoyant economy and stock market). But because boomers had fewer children than their parents, the burden on these children will be that much greater than it was on the boomers themselves.

In effect, our demographics have pulled forward prosperity from future years. Had there been more children in the West in the 1970-2000 period, there would have been less overall prosperity during that time, but we would now look forward to stronger domestic demand and a stronger economy going forward.

Note in the table below that the dependency ratio of Japan bottomed around 1990 which is the year when its stock market reached its all-time high; and that the dependency ratios in Europe and the US bottomed a few years ago around the time when stock markets reached their 2007 highs. The fact that several stock indices are now at higher peaks than in 2007 can be largely credited to America’s faster pace of innovation and to near-zero interest rates. Case in point: Apple’s market value has more than tripled since 2007.

India will soon be the most populous country in the world but because its dependency ratio is still declining, its growth profile may improve in future years. The same is true of Subsaharan Africa where the fertility rate is still high but declining steadily thanks to improved health care for women and declining infant mortality. As such both India and Subsaharan Africa could see faster economic growth than elsewhere, provided the institutional framework can be improved towards less corruption and more efficiency.

Europe is in a bind in the sense that, even if it had the wherewithal to do so, it cannot now raise its birth rate without making its demographic situation worse in the near term (by raising its dependency ratio faster). For the foreseeable future, its economy will become even more dependent on exports towards the United States and emerging markets. The new frontier for European exports may well be in the old colonies of the Indian subcontinent and of Subsaharan Africa.

 Dependency Ratios  1950 1970 1990 2000 2010 2015 2020 2030 2050
 World  65 75 64 59 52 52 52 53 58
 Brazil  80 85 66 54 48 45 44 46 59
 Russia  54 52 50 44 39 43 48 54 67
 India  68 80 72 64 55 52 50 47 48
 China  63 77 51 48 38 38 40 45 64
 Europe  52 56 50 48 46 50 54 61 75
 Japan  68 45 43 47 56 65 70 75 96
 USA  54 62 52 51 50 53 56 64 67
 Africa  81 91 91 84 78 76 73 67 59

2011-14 GDP Forecasts vs. S&P 500

This is the fourth year in a row that GDP forecasts had to be ratcheted down. But the S&P 500 has powered ahead, in large part thanks to near-zero interest rates.

The GDP forecast for 2014 now stands at +1.7%.

Facebook in a Perfect World

24 July 2014


Using Google as a comp for future growth and valuation.

Last Thursday, Jim Cramer compared Facebook (FB) to Merck (MRK). According to this Seeking Alpha report,

Cramer compared Facebook to the early days of Merck, when many were skeptical about the value of the big pharma company. Some declared Merck “the most overvalued stock on Earth,” because its valuation surpassed that of General Motors (GM). Cramer had to face angry clients when his hedge fund held Merck, but his call ended up being a winner; Merck’s products ended up becoming the biggest blockbuster drugs of all-time.


Facebook has real earnings. Cramer thinks FB could earn $3 per share for 2016, and it has 60% growth. This means it should trade at $90, a 30% premium to where it is currently trading. CEO Mark Zuckerberg outlined a multi-year growth strategy. Cramer thinks it is “preposterous” that FB is that cheap. A couple of years ago, FB had no mobile strategy, and now it is the “king of mobile.” User-generated content is good for gross margins and for advertisers. Facebook may be one of the most lucrative stocks of the era.

Unless I am missing something, the business model of Facebook has zero in common with that of Merck. But even if I was wrong about this and Merck and Facebook were similar in some ways, it would still be possible for Cramer to be right about Merck back then and wrong about Facebook today. As to Facebook’s valuation, $75 may be cheap when we look back years from now, but only if the intervening years deliver on today’s more bullish forecasts. A long-term promise is not as good as a near-term projection. And on this and next year’s metrics, the stock certainly looks richly valued.

I mention Cramer to make a point about the way investors influence each other’s decisions. I wrote recently that, because investors and traders influence each other, for example through shows like Cramer’s Mad Money or articles on Seeking Alpha or other platforms, large cap stocks like Facebook and Apple (AAPL) could at times be mispriced by very wide margins of 20%, 30% or even 50%+. We certainly saw how this could be the case in the bubble of 1999-2000 and again in 2006-07. And we are now again in a similar ‘influence’ game which further pushes up market favorites, against a very helpful backdrop of near-zero interest rates.

Instead of Merck, the company that is probably a good comp to Facebook today is Google (GOOG). Not a perfect comp, but close enough. So here is a comparison of their evolution.

Facebook’s market cap is now very close to $200 billion. Its projected sales for 2014 are around $12 billion, which means that its stock is trading at over 16x forward sales. To many, this valuation seems justified by Facebook’s very high margins and growth rates.

Google’s market cap reached $200 billion for the first time in 2007. Back then, its revenue growth rate was similar to that of Facebook today (not far from 60%) and its margins were slightly lower. Google stock in that year traded in a range of 8 to 14x sales, significantly lower than Facebook today.

Judging by what happened in subsequent years, you could say that Google’s 2007 peak valuation was justified. Since then, Google’s market cap has doubled to exceed $400 billion today. So if you are a Facebook bull, you can pencil in $400 billion as a target market cap and $150 target stock price.

The main problem with this logic is that things rarely evolve in a linear fashion. In other words, on the road to $400 billion and $150, we may first see $100 billion and $38.

An investor who bought Google stock in late 2007 and who held until today has outperformed the S&P 500 by a wide margin. But all of this outperformance has occurred in the 18 months from July 2012 to December 2013. In 2008, Google stock crashed like everything else, falling by two thirds, and its stock did not regain its 2007 high until late 2012.

Nonetheless, despite the 2008-09 crisis, Google sales continued to grow, albeit at a lower rate. Revenue growth was 56%, 31%, and 9% in 2007, 2008 and 2009. It reaccelerated in the subsequent years 2010-2013, to 24%, 29%, 32% and 19%.

  2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
 Google  92% 73% 56% 31% 9% 24% 29% 32% 19% 21%
 Facebook  37% 55% 65%

(Tables show 2014 year to date.)

As shown in the table, these are attractive growth rates but a far cry from what they were in the years to 2007. Even if you ignore the 2008-09 collapse, sales growth at Google has been on a long-term downward trend. It is very difficult if not impossible for a large company to maintain 50% growth rates.

  2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
 High  21.6 14.9 14.1 10.1 8.4 6.9 5.5 5.1 6.3 5.8
 Low  8.4 9.7 8.3 3.6 3.8 4.8 4.1 3.7 3.9 4.9
 High  21.0 19.0 16.0
 Low  8.2 7.3 11.2

Going back to Facebook, there are no doubt multiple justifications to hold the stock: the increased role of mobile, the potential for higher revenues per user, the integration of acquisitions etc. But a long position is betting on both flawless execution and a supportive macro environment.

At current valuations, the stock is priced for perfection not only at the micro level (its own operations) but also on the macro level (the overall economy and market). The odds are we will not see a major crisis like 2008 again soon, but what happens to Facebook stock if the economy slows down? Advertising is a notoriously cyclical business. What if Facebook’s own growth rate slows from 60% to a still strong 30%, as happened at Google? From a level of 16x sales, Facebook’s stock would certainly fall by 20%, 40% or more, depending on the severity of the slowdown.

Disclaimer: The views expressed here are not intended to encourage the reader to trade, buy or sell Facebook stock or any other security. The reader is responsible for any loss he may incur in such trading.

Large Stocks Are Chronically Mispriced

11 July 2014


When investors influence each other’s decisions, the stock market becomes less efficient.


A different perspective

Conventional theory holds that the stock market is ‘efficient’ and that it does a good job pricing stocks at or close to their fair value, in particular the stocks of large widely followed companies. But could the opposite be true? Could it be that the larger and more followed companies are the less efficiently priced by the market? Could it be that their market value is chronically 20%, 30%, or 40% off from their fair value?

Here is the theory. Assume that there are only 1,000 investors who are active in the stock market and that they each independently derive a value for each stock in the S&P 500. ‘Independently’ here means ‘without sharing thoughts with each other and without letting themselves be influenced by other sources’. Under these admittedly improbable circumstances, the resulting level of the S&P 500 would be quite close to ‘intrinsic value’. We could say that the market would be ‘efficiently’ priced.

Now assume instead that the 1,000 are not working independently but that they influence each other, sharing valuation models, qualitative opinions, price targets, etc. Under these circumstances, the level of the S&P 500 would deviate, in some cases significantly, from its intrinsic value. The market would be inefficiently priced.

This at least is the theory and conclusion you can draw from some recent research on collective decision-making. A recent article titled When Does the Wisdom of the Crowds Turn Into the Madness of the Mob? explains it (my emphasis):

When can we expect a crowd to head us in the right direction, and when can’t we? Recently, researchers have begun to lay out a set of criteria for when to trust the masses.

Democratic decision-making works well when each individual first arrives at his or her conclusion independently. It’s the moment that people start influencing each other beforehand that a crowd can run into trouble.

Philip Ball, writing for BBC Future, describes a 2011 study in which participants were asked to venture educated guesses about a certain quantity, such as the length of the Swiss-Italian border:

“The researchers found that, as the amount of information participants were given about each others guesses increased, the range of their guesses got narrower, and the centre of this range could drift further from the true value. In other words, the groups were tending towards a consensus, to the detriment of accuracy.”

“This finding challenges a common view in management and politics that it is best to seek consensus in group decision making. What you can end up with instead is herding towards a relatively arbitrary position.”

If the research is valid, it debunks the idea that a widely followed stock is efficiently priced. It is not uncommon to hear someone say: “this stock is followed by so many people that I have no edge investing in it”? The opposite is almost certainly true: the more widely followed a stock is, and the more ‘influence’ is traded between the participants, the more certain you can be that its market price is wrong, and possibly wrong by a substantial margin.

Take Apple stock for example which is followed by a large number of analysts and investors. When it comes to AAPL price targets, can we say, to paraphrase the article, that the “range of their estimates got narrower, and the center of this range has drifted further from the true value?” And are investors as a group “tending towards a consensus, to the detriment of accuracy?” Investors tend to cluster their price targets not far from the current price which is now $95. But we can theorize that Apple’s intrinsic value is not $100 or $90. It is probably much further from its current market price, say $70 or $120.

Another conclusion can be drawn. When discussing their investment process, fund managers tend to put emphasis on the individual expertise of sector analysts and on their team’s collaborative discussions. In a typical model, the sector analyst will initiate an investment idea and pitch it to a fund manager or to a team who will then reach a decision on how to proceed. In this case, the sector analyst may have been influenced by his peers, by the sell-side and by other sources. And the deciding team members, while searching for a consensus, may have been influenced by each other, by the analyst, and by some willingness to defer to the analyst’s expertise.

If you believe the research described above, this is not the best approach to choosing investments for a portfolio. A better approach would be to have 5 or 10 analysts value the same stock independently, without looking at other sources. It might also be better if these analysts were generalists instead of sector specialists who may be biased in favor of their sector. Once the work is done, there is no point in having any discussions which may prove to be counterproductive. In theory, ‘discussion’ means ‘influence’ and it would result in more bad decisions. It is better to simply look at the valuations derived by these independent analysts. If the average of their price targets is way off the market price, it would be worth initiating a position.

Coach: Two Opposed Ideas

4 February 2014


Coach speaks the language of luxury but it is increasingly running a volume business.

F. Scott Fitzgerald wrote in The Crack-Up (1936) that “the test of a first-rate intelligence is the ability to hold two opposed ideas in the mind at the same time, and still retain the ability to function”.

Whether the same applies to corporate strategy can be the subject of doubt. But it is clear that Coach’s “one brand, two distribution channels” approach has not delivered the growth and earnings expected by shareholders. Coach is trying to elevate its brand in one channel, full price stores, while at the same time unwittingly depreciating the same brand through another channel, factory stores. An outside observer can be forgiven for viewing these efforts as “two opposed ideas in the mind”.

The most successful companies tend to have a clear unambiguous mission and message. But Coach appears to be, on many levels, a company that is mired in ambiguity, or even confusion, which explains why its stock has drifted aimlessly for over a year while peers Michael Kors (KORS) and Kate Spade (FNP) have scaled new highs.

Here are a few questions about Coach, with ambiguous answers:

- Is Coach a luxury goods company?

Yes. Its handbags come with a quality and price tag (several hundred to over a thousand dollars) that put them in the category of luxury for most consumers. It has “full price stores” in prime locations such as New York’s Fifth Avenue. Coach offers accessible luxury at a price point where the European luxury players cannot compete effectively.

No. Coach’s pricing is far below that of European über luxury names like Hermès, Bulgari or Louis Vuitton. Coach derives two thirds of its North American sales from lower-priced sales at factory outlets. That is nearly half of total sales, a percentage that is too high for a true luxury company.

In addition, Coach runs too many discounted sales for a luxury company. Between Thanksgiving Week and the end of the year, I counted no fewer than a dozen discounted sales on Coach’s Twitter account. (Side note: It is not clear why Coach advertises some of its discount sales as “Semi-Annual”. This practice encourages some customers to just wait a few months for better prices).

Semi-Annual Sale

Coach Stock: Another Semi-Annual Sale

- Will Coach be a growing company again?

Yes. The company is seeing rapid growth in its men’s line and in international sales, most notably in China. International comps will improve in 2014 as the Yen’s near-30% decline phases out gradually. An acceleration in the US recovery will help North American sales rise again.

No. North America sales are in decline due to structural, not cyclical, reasons, in particular the aging of Coach’s customer demographic.

- Does Coach have a strong management team?

Yes. Coach is highly profitable, generates strong cash flow and has no debt. Management has taken decisive steps to develop new revenue streams. For example, the men’s line now accounts for over 10% of total sales. And sales in China are booming.

No. Coach was too slow to develop a foreign presence. In North America, an overreliance on factory outlets has damaged the brand. And the effort to transform Coach into a broader lifestyle brand raises its risk profile since it is no longer just “sticking to its knitting”.

- Is Coach still a hot brand?

Yes. Coach’s new creative director, Stuart Vevers, will reinvigorate the brand with new products that will be introduced this week at Fashion Week in New York.

No. Michael Kors, Tory Burch, Kate Spade are the new hot brands. Coach is associated with an older demographic and is past its prime. It will be difficult to rejuvenate the brand.

- Is Coach a good investment?

Yes. It has a low valuation and strong cash generation. Growth will return in 2014. The disconnect between valuation and profitability will correct itself through a rise in valuation.

No. North America will remain a problem for a long time and margins will continue to erode. The disconnect between valuation and profitability will correct itself through a decline in profitability.

Scale vs. Exclusivity

Adding to the confusion are some statements by Coach executives in recent weeks. Here are two examples:

Francine Della Badia, President of North American Retail, at a Morgan Stanley Conference (full transcript here): [my emphasis]

“We’re very proud of our factory business and our factory consumer, and if you think about economics alone, there is more scale available to us to participate in a handbag category that’s under $300 than at our full-price average unit retail of $300. So I love our factory business, I’m very proud of our factory business.”

If I am interpreting this message correctly, Ms. Della Badia is saying that Coach can make more money selling a large number of sub-$300 handbags at factory outlets, than a smaller number of higher priced handbags at full price stores. This is disconcerting talk from a luxury goods company.

But it fits a now familiar pattern: Coach likes to speak the language of luxury but it is largely pursuing a mass-market volume strategy. Coach continues to open new stores at factory outlets.

The second statement is from Coach’s recent earnings call in which Kimberley Greenberger of Morgan Stanley asked whether the outlet business damages the brand. Although we all know the straight answer to this question, the circuitous response offered by new CEO Victor Luis was revealing (full transcript here): [my emphasis]

GREENBERGER:  “Victor, you mentioned the endeavor to restore brand equity, and I’m just wondering, how do you think about that effort over time with the ongoing increase in square footage in factory? It would seem in some ways that those two things worked against one another, given that typically expansion in factory is not really brand enhancing. It certainly increases distribution opportunity, but having more discount product out in the marketplace would not really seem to be congruent with the effort to restore brand equity. So I’m just wondering if you can help us with how you think about those two opposing forces.”

LUIS: “It’s obviously a question we get often, and what I would share is that we believe the brand, first and foremost, must be led through the full price channel. And what you see, again, in Lower Fifth, what you see in South Coast Plaza, in terms of a direction for the future of our fleet and the equity that we want to drive through that fuller lifestyle experience, where consumers are engaging with the brand differently, without a doubt will be both a business driver but just as important, if not more so, the halo for the entire multichannel strategy that we have.”

“Outlets, in terms of their importance globally, are unquestionably the fastest growing certainly bricks and mortar channel in the luxury space. That is not only true for U.S. based multichannel brands. It is increasingly true for European and traditional luxury brands who are driving further relevance for the channel globally, whether it be here in the U.S., where it’s quite a mature channel, but of course increasingly in Europe, and now, more than ever, increasing in China and the rest of Asia as well. And so as that channel grows, we want to make sure that we participate in it, and take our fair share there.”

And further:

LUIS: The key is not just to see it as a promotional channel, but to see it as a channel which is of relevance to a certain consumer, who does not shop in other channels, and where we have the leadership position and see continued growth moving forward.”

What Mr. Luis is saying, again if I am interpreting this correctly, is that the full-price store is an important driver of the company and “just as important, if not more so”, it is a place to valorize the brand and the factory outlet business. If this means that the luxury higher end business is an important place to advertise the factory outlets, then we are in tail-wags-the-dog mode with full-price stores seen as essential to boost factory sales, instead of factory stores seen as an unfortunate but needed outlet to clear some excess inventory.

Both Ms. Della Badia’s and Mr. Luis’ statements indicate that the factory store is one of the company’s core businesses, if not the main core business. But this business poses a threat to brand equity, to growth and to profit margins.

Losing Exclusivity

Coach’s strategy dilutes its “exclusivity”. In a recent study on the global luxury industry and survey of 10,000 core luxury consumers, the Boston Consulting Group (BCG) and Altagamma indicated that 25% of luxury brands are at risk of losing their exclusivity. Antonio Achille, partner and managing director at BCG, said this: [my emphasis]

“Exclusivity is a core attribute that a brand and a product must have for core luxury consumers. Brands need to recognize that there are several ways to lose exclusivity, some of which can be only partially controlled, such as fake copies, but others are in control of the brand, for instance, discounting too often, too intense use of licenses or poor distribution. Once exclusivity is lost, the equation to rebuild it is very complex, takes time and there is no guaranteed success.

In my last article on Coach, I speculated that it may be the target of a takeover. Since then, the stock has made a round trip from the high 40s to the high 50s and back. This is yet another iteration in a tug of war between some investors who have given up and others who keep waiting for Coach to perform.

Fitzgerald’s next sentence in The Crack-Up was: “One should, for example, be able to see that things are hopeless and yet be determined to make them otherwise.”

Will Coach shareholders make things otherwise?

P.S. Michael Kors reported another stellar quarter this morning.

Disclaimer: The views expressed here are not intended to encourage the reader to trade, buy or sell Coach stock or any other security. The reader is responsible for any loss he may incur in such trading.

Euro: Austerity, Breakup or Devaluation?


In a new book, Nomura’s lead currency strategist warns that the Euro is on an unsustainable path.

“I wrote this book because I care about Europe”, writes Jens Nordvig in the preface to The Fall of the Euro.

This passion and the author’s scholarship shine through in the subsequent pages. European by birth and living in New York, Nordvig, who is Global Head of Currency Strategy at Nomura, has a unique understanding of the factors that led to the creation of the Euro, and of the impact that the Euro crisis has had on financial markets.

He also has some unsettling insights about the future.

Breakup or Exit

Many people have speculated on the breakup of the Euro. But is a breakup feasible?

Legally speaking, It would be relatively easy for each Eurozone country to redenominate the Euro assets and liabilities which are within its jurisdiction back to its national currency. But, writes Nordvig,

“What would happen to financial assets and liabilities that were outside the jurisdiction of the Eurozone countries if the euro ceased to exist?… What would happen to a loan made in euros by a US investment bank to a big industrial company in Poland? Would the loan now be in US dollars? Would it now be in Polish zloty?… The lender might have one preference and the borrower another. There would be a potential dispute of this nature for every single financial contract…These disputes would be the catalyst for widespread legal warfare…There would be trillions worth of assets and liabilities denominated in “zombie euros” and outside the reach of Eurozone governments… There was no example of this in history.”

If the obstacles to a full breakup seem insurmountable, the exit from the Eurozone by one or several countries look by contrast to be more manageable. Here as with many Euro-related decisions, the outcome will likely be dictated by politics.

Although the weaker countries are seen as likely candidates for exit, Nordvig notes that any benefit they would derive from reverting to their weaker national currencies would be largely offset by the magnified burden of having to service their Euro-denominated debts.

Nordvig also explores the scenario of a German exit, an option which he views as feasible but improbable.

Austerity or Devaluation

A “hard currency equilibrium” has prevailed since 2012 but this equilibrium is entirely dependent on periphery countries (Italy, Spain, Portugal, Greece, Cyprus) sticking to tough austerity measures. In this scenario, adjustment will take several years before a strong recovery can return.

Should austerity prove unsustainable, the Euro may find a “soft currency equilibrium” in which debt limits are ignored and rescue conditions are relaxed. According to Nordvig, this could turn the Euro into a weak currency not dissimilar to the former Italian Lira.

Bond spreads have tightened and stocks have risen since the dark days of 2012 but Nordvig cautions against complacency:

“Investors should be on the alert and not be fooled by the relative market calm observed since the summer of 2012. There is a difference between bond yields that are consistent with fundamentals and yields that have been artificially pushed lower as a result of insurance from the core.”

Coach: Ripe for Takeover?


(also published at Seeking Alpha)

“International sales decreased slightly…”

That’s a sentence you do not want to see when you are looking at a company which is viewed by many as a significant player in the booming global luxury goods sector. And yet, there it is, in Coach’s first quarter report released a few days ago. To be fair, the slight decrease in sales was due to rare and large currency fluctuations. The dollar rose by 27% against the Yen in the last year, an extreme move not often seen with major currencies. On a constant currency basis, international sales rose 9% in the quarter, which is reasonable but not a barn burner. A bright spot was China where sales boomed 35%. So there was some good news behind the headline.

Despite the Q1 disappointment, Coach’s net income and free cash flow margins remain strong. Its main problem is not profitability but the fact that North America contributes 67% of total revenues and has essentially gone ex-growth.

If you put Coach in the bucket of luxury goods companies (which are mostly European), it is clear that Coach is badly underperforming. Sector peers LVMH, Burberry, Richemont and others have zoomed ahead with sales, profits and stock prices not far from their all time highs. The main reasons for their greater success have been their more aggressive expansion into Asia and stronger brand management.

But if you put Coach in a more general bucket of consumer and apparel companies, then it is doing better than some and worse than others. The issue however is that the company’s future will be largely determined by which bucket it puts itself in. As a luxury goods company, it can maintain some pricing power and it will preserve or raise its margins and market value. It could also merge with or be acquired by one of the Europeans. But as a general consumer company, its brand will get tarnished. Its margins will continue to erode and so will its valuation.

Coach’s problems can therefore be summed as follows:

-          An insufficient geographic footprint outside the US.

-          A large North American presence which has stalled.

-          A brand that is in danger of falling out of the “luxury” sector.

The store opening program can be accelerated overseas if there is sufficient confidence that the luxury boom will continue. Coach has a strong balance sheet and is generating positive free cash flow. In theory, therefore, it has important untapped reserves which it can deploy to open stores at an accelerated rate.

North America will be more difficult to fix, given intense competition from the likes of Michael Kors and Kate Spade. Here, design appeal and brand management are key to an eventual recovery. Coach faces the risk of what the French call “Cardinisation”, the fate met by the Pierre Cardin brand when it became so ubiquitous that it lost its luxury stamp.

In this sense, the fact that 60% of Coach’s North American sales occur in factory outlets is positively troubling. Sales at these outlets come at better margins because of lower costs and higher volumes but they damage the brand and could reclassify it outside of the luxury sector. And that could be the beginning of a death spiral for pricing.

A quicker fix would be to sell the company to another luxury goods firm. An acquirer who already has a large presence in Asia and Europe could quickly boost Coach’s overseas revenues and lower its costs. Conversely, Coach’s large US presence could be of benefit to an acquirer looking to grow its own American sales. One problem is that a buyer may initially look to strengthen the brand by closing some factory outlets. This could reduce North American volumes in the near term, a consideration which may depress any proposed takeover premium.

So is this a good price to buy the stock?

Yes, because international sales growth will soon return and for the possibility of a takeover.

No, because branding issues and North America are unlikely to be resolved in the next quarter.

All in, it is a buy for speculative portfolios. More conservative investors should look to buy at a lower price if the company takes steps to avoid further erosion of its margins and to move its brand upscale.

Note: Last year, I wrote more generally about prospects for the luxury goods sector.

Disclaimer: The views expressed here are not intended to encourage the reader to trade, buy or sell Coach stock or any other security. The reader is responsible for any loss he may incur in such trading.

Weak GDP Growth Reflects Poor Demographics

26 June 2013

GDP growth for the first quarter was only 1.8%, less than the expected 2.4%. Since the recession of 2009, the recovery has been anemic compared to previous ones. See table below. There are some features which differentiate the 2008-09 recession. Most notable among them was the crisis suffered by the major banks and their subsequent inability or reluctance to lend. Another factor in the current recovery, and in our view a more substantial one, is the poorer demographic picture in the US which has resulted in weaker demand growth.

 Number of quarters with n+ GDP growth
 in the 15 quarters following recession of:
n —-> 2% 3% 4%
1991 12 8 7
2001 11 7 2
2009 8 3 2

31 July 2013 Update: GDP growth for Q1 was revised down again today to 1.1%, less than half the estimate from two months ago.  The first estimate for Q2 is 1.7%.

Nokia: The Path To Recovery


(also published at Seeking Alpha)

What this country needs is a good $99 smartphone.

That’s what Thomas R. Marshall, Woodrow Wilson’s Vice-President (1913-1921), might have said today instead of ‘a good five-cent cigar’. Smartphones are still very expensive, at least at the pre-subsidy price. Carriers pay over $600 for top-end phones and ‘subsidize’ customers who pay a discounted price if they commit to a multi-year wireless plan. But prices are destined to fall in the next few years. Within a decade, we could be looking at a $99 phone (pre-subsidy) which will approach the same functionality as today’s flagship phones.

Regarding their competitive strategy, there are two ways for smartphone producers to deal with this evolution.

1. A Top Product Strategy

One way is to start at the top with the best possible product and to continually improve its features. The flagship phone produced by each company can then remain at prices similar to today’s prices but its capability will grow year after year. This seems to be the strategy followed by Apple with each of its product lines. Each has a similar price as a few years ago but its functionality is much greater.

This strategy however has its limitations: at some point, whether it is in 2013 or in 2018, a majority of the buying public will not care as much about new features because the new phone’s capability will far exceed whatever need or use the consumer may have for it. Adding music and cameras was huge. Adding wifi was huge. Adding apps was huge. At some future date, they will be adding things that only tech geeks, or the few people who use their phones’ full capability, really care about. Even within the apps catalogue, most of us will truly care about only a dozen or so. And most of us are rarely more than thirty minutes away from our personal or work desktop computers. There are truly very few apps we ever need to use urgently, in less time than it takes to reach a desktop.

For companies with a product strategy, it is a challenge to keep people interested in new features. And it is a race against time to release these features on a schedule which will preserve high prices and high margins. In most such races against time, time ends up winning.

2. A Bottom Price Strategy

The other way for smartphone producers to deal with new competitive pressures is to start from the bottom with a preset price for a phone and to see how many features can be packed in at that price while the phone is still profitable. So say a company chooses $99 as a price before subsidies and it sets out to discover how good of a phone it can deliver at that price. The first few phones priced at $99 will look very inadequate. But here, unlike with a product strategy, time is an ally. The more time goes by, the better the $99 phone will become. In the future, a $99 phone will be as good as an iPhone 5 or a Samsung Galaxy S4.

Asha Rising.

Asha Rising.

The question then is which company would you rather be? Would you rather be the first company racing against time trying to slow down margin erosion by offering more and more features, while hoping that customers will still want them? Or would you rather be the second company, with time as an ally, securing a growing segment of customers who want a low price and who only use a few apps on a regular basis? In the early days of the smartphone, when new features addressed important market wants and needs, I would have to put my money on the first company and it made sense to invest in Apple. Going forward, I would have to put my money on the second company.

Industry Shift to Dumb Smartphones

This is where Nokia could make a strong comeback. I have no idea whether it will pull it off, but it has a plausible path to recovery. Nokia lost the first smartphone round to Apple and Android. It could gain market share in the high end with its Lumia Windows Phone 8 phones but this looks like a difficult proposition, as noted by many authors here. It is not enough for the Lumia flagship to be as good as a top Apple or Android phone; it has to be significantly better or its price has to be much lower to compensate for consumers’ inertia, brand loyalty and switching costs. You may not consider a top Lumia phone if it is $50 cheaper than an iPhone but you would consider it if it was $100 cheaper and if you are not too rooted in the Apple or Android ecosystem.

Within the Lumia range, Nokia recently introduced the Lumia 521 priced at $150 with no contract, but its margin on this phone is probably low, or possibly negative. The challenge for a ‘bottom price strategy’ is to deliver a low-price phone which is still profitable for the manufacturer. Entry level phones like the Lumia 521 may be unprofitable and positioned as loss leaders to gain market share and to attract buyers in the hope that they will later migrate up to more profitable phones.

Generally speaking, when comparing Lumia to iOS (Apple) and Android (Samsung and others), there is rarely room for a number three to prosper in a space that is dominated by two aggressive well-financed players. Lumia has been gaining market share but it has yet to break into double digits.

Instead of banking too much on Lumia, Nokia can instead win the next round when prices start to fall quickly, or to put it differently, when the functionality of inexpensive phones starts to rise quickly. That is why, of Nokia’s two recent phone launches, the Asha 501 was in my view the more exciting. Not because of the phone itself, but because of the strategic shift it may bring. While the industry’s heavyweights are battling to claim the title for the smartest smartphone, an increasing number of consumers will be satisfied with a low-priced ‘dumb smartphone’.

The Asha 501 is priced at $99 and its functionality is very limited today. See CNET’s video review of the Asha 501 and a review by TechCrunch. But as noted above, its capability is only going to improve in coming years. Launched in India, it will ship in June via 60 carriers in 90 countries, mainly in emerging markets and Europe, but not the US. Instead of Windows Phone, it uses the Smarterphone OS, a stripped down operating system, and runs on 2G GSM networks. Not exactly the kind of stuff that would get an American buyer excited. But at a future date, Nokia may be able to launch a much improved low-priced phone in the US. Of course, Apple and Samsung can do the same but they are hamstrung by their high stock prices and the market’s expectation that they will maintain strong margins. Nokia has no such “problem” since its stock and margins are now distressed. Low expectations can sometimes be an advantage. (The same applies to other players who have fallen behind and have little to lose.)

To be sure, there are already lower priced or even free iOS and Android phones sold by the US carriers. For example, AT&T sells the 8GB iPhone 4 for 99 cents + an activation fee of $36 and a two-year contract. But a $99 price for an Asha-like phone, pre-subsidy or without contract, would still be significantly cheaper. AT&T sells the iPhone 4 without contract for $450.99.

In recent years, the key success factors in the smartphone business were product and technology. As prices tumble and consumers’ appetite for more functions start to fade, the new success factors will be price, manufacturing and logistics, all factors at which Nokia has excelled in the past. Perhaps it can do it again. If it does not, someone else will.

Disclaimer: The views expressed here are not intended to encourage the reader to trade, buy or sell Nokia stock or any other security. The reader is responsible for any loss he may incur in such trading.